This article is written by Afif Khan, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho, as a part of his coursework.
What are the securities?
In layman terms, security is a financial asset that has some monetary value and is used by the companies to raise capital, while it is used by the investors to invest in a company.
In India, securities are defined under The Securities Contracts (Regulations) Act, 1956, in which according to Section 2 (h), securities include “shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate”[1]
The Companies Act, 2013 also makes a reference to the same definition and according to Section 2 (81) securities will have the same meaning as defined above.
What are the different types of securities used in the corporate world?
The securities can be broadly divided into four types based on their function and operation. These four types are equity securities, debt securities, derivative securities, and hybrid securities.
Equity Securities
These are the type of financial instruments that give an investor an ownership position in a company. The most common type of equity securities are stocks that an investor buys. To calculate a person’s ownership percentage in a company we have to divide the number of shares the person owns in a company by the total number of shares the company has and multiply it by 100.
The benefit of investing through equity security is that there is virtually no risk of default by the company. Your profit or loss is commensurate to the ownership that you exercise in the company. This means that if company X is making a profit of Rs. 1000 on a particular day and you exercise a 20% ownership in the same company then your profit will be Rs. 200.
Debt Securities
These are the type of financial instruments that enable a company to raise capital by borrowing from the public. The most common instrument used by the companies to raise capital through debt securities is a bond.
How these bond works is that a company issues bonds of a certain value that have a maturity period at which the company promises to pay the amount mentioned in the bond. The value that the company promises to pay at a later time is usually more than the value of the bond it offered, providing an incentive for investors to buy the bond.
Further, depending on whether the bonds are sold at a value lower than their face value or whether they are sold at their face value but appreciation is based on the interest they are called as zero coupon bonds and bonds respectively.
Derivative Securities
It is a type of financial instrument whose value depends upon another underlying financial instrument or another underlying promise or contract. It is called derivative because its value is derived from another promise, contract, or financial instruments like stocks or bonds. A swap, futures contract, and options are some of the examples of derivative securities.
Apart from these three kinds of securities, there is also a fourth kind of security used which does not fall into any of the above-mentioned heads, because of its nature, called hybrid security.
What are Hybrid Securities?
Hybrid Securities are financial instruments that have mixed characteristics of two or more different financial instruments like stocks or bonds. These are defined under Section 2 (19A) of the Companies Act, 1956 as “any security which has the character of more than one type of security, including their derivatives”[2] These are hence called as ‘hybrids’ because they have mixed characteristics of both equity and debt.
The Supreme Court dealt with the issue of whether ‘hybrid’ securities are ‘securities’ as per the scheme of the Companies Act and SEBI Act in the case of Sahara India Real Estate Corporation Limited & Ors. v. SEBI[3].
In this case, the Supreme Court held that ‘hybrid securities’ are securities within the meaning of the Companies Act, Securities Contracts Regulation Act and hence the SEBI Act too.
It based its decision on the fact that Section 2 (h) of the Securities Contracts Regulation Act, 1956 defines securities to include “shares, scrips, stocks, bonds, debenture stocks, or other marketable securities of like nature in or of any incorporated company or other body corporate” and that the term ‘hybrids’ has been defined as ‘any security having the character of more than one type of security’[4] and since these securities are ‘marketable’ they would fall within the meaning of securities for the purposes of Companies Act, Securities Contracts Regulation Act and the SEBI Act.
With that established let’s look at what are the advantages of using hybrid securities.
What are the advantages and disadvantages of using Hybrid Securities?
Advantages
- Higher yield: Hybrid securities are generally placed subordinate in the capital structure and hence offer a high rate of return than senior debt.
- Less volatility in market price: Hybrid securities have less volatility in the market because they pay a regular, pre-determined, distribution of market returns.
- Diverse nature: Hybrid securities are, as mentioned above, not bound by any strict definition of either equitable securities or debt securities and hence can diversify the overall risk portfolio while again, guaranteeing attractive returns and hence, improving a firm’s risk profile.
Disadvantages
- Complicated: Investing through hybrid securities is considered more complicated than investing through equity or bond securities.
What are the different types of Hybrid Securities and what are their features?
While there can be many types of hybrid securities, for the purpose of this article, we are only going to deal with the 5 most popular ones such as:-
- Convertible Bond
- Preferred Shares
- Mezzanine Financing
- Toggle Notes
- Warrants
Convertible Bond
A convertible bond is a type of security that gives the investors a bond along with the power to convert that bond into stocks of the same company. It is a type of hybrid security because its nature as a bond makes it debt security while this nature changes into equity security when it is converted into a company’s share.
Convertible bonds are sought after because apart from paying regular income through a bond’s coupon payments these bonds also give the investor an ability to convert the bond into shares of a company.
To do this conversion, however, a conversion formula is used by the investors. This conversion formula is usually pre-determined and it gives a conversion ratio as to how many shares would a person get if he/she converts the bond into the stocks of the company.
To determine when it will be beneficial for investors to convert their bonds into stocks a conversion price is used. If the price of common shares is lower than the conversion price (a conversion price is the price of one share that is valued according to the bond) then it is not beneficial for the investor to convert, however, in an opposite situation where the company is earning a lot of profit and its price of common share is more than the conversion price then it is profitable for the investors to convert the bond into common shares and sell them.
This way, investors with convertible bond get profit when the company is earning profits, this is apart from the security of getting money when a company is not doing well in the market and its rate of stocks are going down.
Preferred Shares
Also called preference stocks, these are shares of a company that are paid before the common shares of a company in case of bankruptcy.
Preferred shares are hybrid shares because they possess features of both equity and bonds.
Like equity, preference shares
- Pay dividends
- Don’t have a maturity period
- Under certain circumstances, may give shareholders a right to vote.
Like bonds, preference shares
- Require the company to make regular, pre-set payments
- Do not carry voting right, generally, for investors
- Don’t grant a claim on the company’s profits
- Receive credit ratings and their market price is also determined by the credit ratings and direction of interest rates.
Preferred shares are more sought after as compared to the common shares because of the aforementioned features. While the preferred shareholders get dividends before the common shareholders in case of bankruptcy, they still dividends after the bondholders.
Mezzanine Financing
It is a type of security that involves both equity and bond like features and combines both to give effect of a hybrid security. It is a kind of security in which a loan is given to the company by the lender, however, the lender can assume ownership position through acquisition of shares if there is a default on loan by the company. This again, helps the lender to have secured payment through the loan and in case of default, gives the lender an equity in the company.
Toggle Notes
It is a kind of debt security that gives the company an option to defer payments in exchange for a higher rate of interest.
Toggle notes are like bonds in nature, and functioning. They mandate the company to pay interest, and they are a way of borrowing from public by the company just like a traditional bond, however, when it comes to a difference between them and a traditional bond, toggle notes provide the company an option to defer a payment in situations when it suffers from a temporal cash-flow problems in lieu of a higher rate of interest and make the payment at a later date when the temporary cash-flow problem subsides. This helps the company avoid a default in payment and avoid the temporary cash-flow problem.
Warrants
These are a kind of security that give the investors a right to buy or sell shares at a particular price on or before a particular date but does not obligate him to do the same.
They are just like call options in their functioning but have some minute differences between them. Firstly, while options are bought/sold between investors, warrants are bought/sold between investors and the company issuing the warrant. Secondly, warrants have a longer life than options, so while an option will have a life of 2-3 years, warrants will have a life of 10-15 years. Thirdly, warrants are cheaper than option in general, which means more number of shares for the same number of prices.
Conclusion
Securities are a financial instrument used by the companies to raise capital. One of the many types of securities is a hybrid security, which is, a rather new concept yet is very popular because of the advantages mentioned above. While there can be many types of hybrid securities, some common ones are mentioned above.
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